Wait to take RMDs, or Add a Roth IRA?

People are presented with many different strategies to minimize
taxes in retirement, Lena Rizkallah, a retirement strategist at J.P. Morgan Asset
Management, said in a recent webcast, “The retirement
Tax Cliff: Maximize Retirement Income
While Managing Taxes.” For example, the Roth individual retirement account
(IRA) has become an important tool to balance the need to use assets and
limit taxes to whatever extent possible, she contends, pointing out that tax
rates are likely to fluctuate depending on the source and total amount of income retirees draw in a given year.

The use of Roth accounts, structured as IRAs or 401(k)s, is gaining
steam, Rizkallah says. “The rules have changed, making it easier for employers
to implement them,” she says. Deferrals average around 4% to 5%. Similar to
Roth IRAs, Roth 401(k)s accept after-tax contributions, but these accounts have no
required minimum distributions (RMDs).

Leveraging tax deferral strategies
has changed retirement planning, Rizkallah feels, and the old rule of thumb, in
which the retiree withdraws first from taxable assets and then from
tax-deferred accounts may not be the best strategy. In fact, there may be
advantages to tapping retirement assets earlier than age 70½, using a Roth
conversion to help minimize taxes in retirement.

To clearly illustrate how the traditional
approach of taking withdrawals at the required minimum age of 70½ compares with
a more proactive one—in which the investor takes early withdrawals from tax-qualified accounts, and invests some of
the assets into a Roth IRA—Rizkallah describes three hypothetical married
couples.

All three couples are the same age,
all retiring at age 60, with a $1 million portfolio, split equally between a
taxable account and an IRA or 401(k). Their holdings were allocated identically—30/70
in equities to fixed income—and they received an identical 5.2% estimated
annual return.

All began to claim Social Security
benefits at age 66 as maximum wage earners; all had an initial spending need of
$75,000 and all drew from their taxable assets first. All died at exactly age
95, giving them all 30 years of retirement (and taxation) to plan for.

Withdrawal Strategies

The variables came at the
withdrawal stage of the retirement accounts. First, imagine a couple named
Diana and Hector Gomez. The Gomezes tapped their taxable assets first, then waited
until they were 70½ to begin taking the required minimum distributions. Using
the traditional approach, according to Rizkallah, the marginal tax rate jumps
to 15% at age 70½.

The next case study is a couple
named Henrietta and Henry Henrickson. Between the ages of 60 and 69, they
withdraw from the tax-deferred account within the existing tax rate, and make contributions
to a taxable account, an approach that allows their tax rate to stay consistent
throughout retirement.

Last, Gabriella and Giancarlo
Zarelli tap their retirement assets and make Roth IRA conversions with the
excess withdrawals, a strategy that keeps their tax rate at 10% throughout most
of retirement.

At the end, the Zarellis wound up
paying the lowest taxes ($53,000) and the Gomezes the highest ($293,000). The
Henricksons didn’t do much better for taxes ($241,000).
The Gomezes also wound up with the lowest ending wealth in their portfolio, at
$1,573,387, and the Zarellis had the highest dollar figure ($1,907,073). The
Henricksons ended up with $1,589,777.

Key conclusions of the JP Morgan
Asset Management’s analysis are:

Clients will continue using tax
deferral as a main source of retirement saving;

Tax planning is key as retirees
navigate the complex tax codes;

Even median-income retirees may
face a marginal tax rate jump when they begin RMDs at age 70½;

A Roth conversion can help
significantly reduce taxes and provide estate planning benefits; and

A proactive approach to retirement
income can help clients to better diversify assets and provide a smooth tax
experience in retirement.